Leverage is the process
of using a (relatively) small amount of money to control a much larger investment.
A call (put) option gives its owner the right to buy (sell) 100 shares
of stock, thus making it an ideal leverage instrument. Let’s look
at a specific example.
You have been researching
Stock ZYX, which is currently $20 per share. You believe this
stock is going to do better than expected when it announces (June 20, 20002
or the day before the June options expire) its earnings in a few weeks.
You believe the stock is well priced and are willing to buy some now.
The quantity you want to own is 1000 shares. These are your choices:
Buy 1000 shares of stock.
Cost $20,000.
Buy 1000 shares of stock,
using your margin account.
Cash required is $10,000
Borrow $10,000 from
your broker
Buy 10 call options.
Today is May 1
Buy 10 ZYX Jun
20 calls. Price $150 each. Total cost, $1500
ZYX Jun20 call
is an option, giving its owner the right to buy 100 shares of ZYX at $20
per share at any time before expiration (June 21, 2002)
Let’s look at our
choices.
Buying stock
is fine, if you have $20,000 and if you want to invest that much in this
stock.
Buying stock
on margin (borrowing up to 50% of the cost from your broker) is also okay
if
You are willing
to invest $20,000 in the stock
You are in
position to borrow from your broker
You are
willing to use borrowed money for this investment
This
is risky. You may have to repay this money when not ready to do so
Buying
the calls requires only $1500, and allows you to control 1000 shares of
stock
The
good news is that you only invest $1500, instead of $20,000. This
limits your loss (to the entire $1500) if you are wrong and the stock does
not perform as you expect.
The bad news is you may lose money, even if your stock rises in price.
Let’s
look at 3 possible scenarios:
Scenario one. The earning are as expected, and the stock is
unchanged at $20. When expiration arrives, the stock is still $20
and
If you bought stock either on margin, or for cash, your investment is
still worth $20,000. You neither made nor lost money. If you
borrowed money from your broker, you have to pay interest.
If you own the call options, they are going to expire worthless.
With the stock trading at the strike price (20), and with the news you
expected to help the stock in the past, there is no reason for you to exercise
your options and buy the stock. You have lost 100% of your investment.
The good news is that the loss was limited to the $1500 you paid for the
options, but losing 100% is not a happy outcome.
Scenario two. You were very wrong in your research. The
earnings were terrible, and the stock has dropped to $14 per share.
If you bought the stock for cash, your stock is worth $14,000 and you
lost $6000, or 30%
If you bought the stock on margin, you are still a loser of $6000, but
that now represents a loss of 60% of your capital
If you bought the calls, you lost 100%, but that loss is limited to $1500,
or the cost of the calls
Scenario three. Congratulations, you were right on the money!
The earnings were excellent and the stock has jumped to $25.
If you bought the stock for cash, you made $5000, or 25%
If you bought the stock on margin, you made $5000, or 50%
If you bought the calls, you made $3500, or 233%
Your calls are worth $500 each. Since you paid $150, your
profit is $350 each. You have 10 calls, or the equivalent of 1000 shares,
so the net profit is $3500.
Summary
Using options limits the amount of money you can lose
Using options often results in the loss of 100% of the investment
Using options can provide leverage. Scenario three shows a return
of $3500 on an investment of $1500. Using options allows you to own
the equivalent of 1000 shares of stock without having to invest $20,000 (the
usual cost of the stock)
It is the results of the third scenario that keeps those who buy options
returning to try again and again. This is a higher risk strategy
than I recommend, but the very high possible return is addictive to some
people. Later in this series, we will discuss why you are better
off with a much more conservative overall investment strategy.
